Tax Reform Proposal: Examples

November 9th, 2017 Posted by Tax Planning No Comment yet

In the past 3 posts in our series, we discussed how the House of Representative’s tax reform bill would change individuals’ tax rates, amount of taxable income, and their tax credits.  Now, we are going to illustrate how all those changes come together and could affect you.

Example 1

Justin is single and works as a teacher in San Diego earning a $50,000 salary.  Every year, he spends at least $250 on supplies for his classroom.  Justin is renting an apartment with friends.

Under the current tax system (with 2016 tax rates), Justin would owe $5,628 in federal taxes.  This is because he had $50,000 in adjusted gross income and is able to deduct up to $250 as educator expenses.  His standard deduction of $6,300 is greater than his almost non-existent itemized deductions, and his personal exemption is $4,050.  That means his taxable income is $39,400, and he is in the 25% marginal tax bracket.

Under the tax reform proposal, Justin would owe $4,536 in federal taxes.  He still has $50,000 of income, but he is no longer entitled to the educator expense deduction.  His standard deduction is now $12,200 but he does not have a personal exemption.  His taxable income is $37,800, and he is in the 12% marginal tax bracket.

Example 2

Ryan and Amy are married and both work for the City of San Diego earning a salary of $60,000.  Amy also invested into a friend’s business years ago as a passive investor, and has $20,000 of ordinary income per year from that investment.  Ryan and Amy own a house, and owe $400,000 on it.  They will have to pay mortgage interest of $14,000 and property taxes of $7,000.  They made charitable contributions of $2,000.  They paid $5,500 of California income taxes during the year.

Under the current tax system (with 2016 tax rates), they would owe $17,393 in federal taxes.  This is because they have $140,000 in adjusted gross income.  They itemized their deductions and are able to deduct a total of $28,500, and have personal exemptions worth $8,100.  That means that their taxable income is $103,400, and they are in the 25% marginal tax bracket.

Under the tax reform proposal, they would owe $17,200 in federal taxes.  They still have $140,000 of adjusted gross income, but now instead of itemizing their deductions they are taking a standard deduction of $24,400 and do not have a personal exemption.  Their taxable income is $115,600, and they are in the 25% marginal tax bracket.

Example 3

Tom and Carolyn are married and live in California.  Tom is an engineer with an annual salary of $70,000.  Carolyn is a doctor who owns her own practice (as a sole proprietorship), and this year she has $300,000 of business income.  They own a house and owe $1.2 million on it.  They will have to pay mortgage interest of $44,000 and property taxes of $12,000.  They made charitable contributions of $10,000.  They paid $24,000 of California income taxes during the year.

Under the current tax system (with 2016 tax rates), they would owe $85,972 in federal taxes.  This is because they would have $362,976 of adjusted gross income ($370,000 of income less a deduction of $7,024 for self-employment taxes).  They itemize their deduction and are able to deduct a total of $84,587.  That is because their mortgage interest deduction is limited slightly due to the size of the loan, and there is an overall limitation on the amount of itemized deductions they are allowed to take due to their income.  They are only entitled to personal exemptions of $4,698 due to income limitations.

Their taxable income is $273,480, and would have federal taxes of $68,209, but they are in AMT and therefore owe an additional $5,390 in federal taxes.  In addition, due to the amount and nature of their income they would owe $14,048 in self-employment taxes and $873 as a Medicare surtax.  They are in the 33% marginal tax bracket.

Under the tax reform proposal, they would owe $83,882 in federal taxes.  They still have $362,976 of adjusted gross income, and would still be allowed to itemize their deductions.  However, because they cannot deduct state taxes or as much mortgage interest, their itemized deduction is only $40,333.  They do not have any personal exemptions.  Their taxable income is $322,643, and there is no AMT under the tax reform proposal.  They would owe $68,981 in federal income taxes, and the same $14,048 in self-employment taxes and $873 as a Medicare surtax.  Although their total taxable income would have otherwise pushed them into the 35% tax bracket, because 30% of the business income is taxed at a 25% rate they never left that tax bracket.

Example 4

Frank and Mary are married and live in California.  They own a very successful real estate development company together (which is organized as an S-corporation), and will make $800,000 of net profit.  They own a house and owe $1 million on it.  They will have to pay mortgage interest of $38,000 and property taxes of $15,000.  They made charitable contributions of $30,000.  They paid $67,000 of California income taxes during the year.

Under the current tax system (with 2016 tax rates), they would owe $229,772 in federal taxes.  This is because they have $800,000 of adjusted gross income.  They itemized their deductions and are able to deduct $135,339 due to a reduction of $14,661 as a result of an overall limitation on the amount of itemized deductions.  Due to income limitations, they are not entitled to a personal exemption.

Their taxable income is $664,661, and they owe income taxes of $208,872 on that amount.  They owe an additional $20,900 as a Medicare surtax.  They are in the 39.6% tax bracket.

Under the tax reform proposal, they would owe $216,800 in federal taxes.  They still have $800,000 of adjusted gross income, and would still be allowed to itemize their deductions.  However, because they cannot deduct state taxes or as much mortgage interest, their itemized deduction is only $64,000.  There are no personal exemptions.  Their taxable income is $736,000.  They would owe $190,900 in federal income taxes and the same $20,900 as a Medicare surtax.  Although they are in the 35% tax bracket, $240,000 of their business income was still taxed in the 25% tax bracket.

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